8 early warning signs inflation is percolating

Commentary: Investors need to know when price problems are near

BOSTON (MarketWatch) — They don’t ring a bell at the top of a bull market nor at the bottom of a bear market. But when it comes to inflation there are some early warning signs that investors can monitor, according to a new report.

Inflation is relatively low at the moment. But two risks — some type of shock or monetary policy mistake — could potentially spur “significant and sustained increases in inflation,” according to Michael Hood, a strategist at J.P. Morgan Asset Management and author of “Managing Inflation.”

And, thankfully, Hood said in an interview and in his report that there are “eight early warning signs to monitor that will detect growing imbalances that could ultimately lead to upward pressure on prices.”

As a group, Hood said the indicators — ranging from surveys that track inflation expectations and labor-market dynamics to indexes that track and capture global trends in available resources — are flashing green, suggesting there is little cause for concern.

Still, there’s nothing quite like a little heads up, especially given how easy it is to monitor the indicators that Hood says are worth watching.

In his report, Hood gave color-coded ranges for investors to track each of the indicators, with numbers in the green range being safe, numbers in the yellow range being worrisome and numbers in the red range being, well, trouble. Read Hood’s full report, Managing Inflation.

“We tried to give investors ranges that will tip them off to when things might become problematic,” he said. “The idea was to give people information that they could work with themselves.”

When watching for inflation, Hood said investors shouldn’t focus on any one indicator. But should four of the eight indicators enter the yellow or red zones that would be cause for concern.

“We always caution people not to try to find the one magical indicator you can rely on to the exclusion of all others because any one series, however reliable and quality it is, can get pushed around by specific factors,” said Hood. “And so what you are looking for is the weight of evidence. So, if you start to see a number of things, and four is as good a number as any, start to move that’s probably time to question your pre-existing view.”

So, without further delay, here’s a look at the eight indicators Hood recommends watching:

1. 5y5y forward inflation breakeven

According to Hood, the Fed’s preferred market-based measure of inflation expectations is the “breakeven” rate, or the distance between real interest rates in the TIPS market and nominal interest rates on regular U.S. Treasurys. The Fed watches this rate, according to the report, as a gauge of medium-term expectations.

The breakeven rate has averaged 2.7% since 2000, which is slightly higher than the Fed’s 2% inflation target, according to Hood.

Anything below 3% is — in the main — good. But a sustained move significantly above 2.7% — say, to 3% or higher — would signal a possible anchoring of inflation expectations in the market, with a rise above 3.3% putting this indicator in the red, Hood wrote.

The breakeven rate has ticked up from 2.5% when Hood first published his report in August to 2.7% in the wake of the Federal Reserve announcing QE3 two weeks ago. But that’s not a cause for concern yet. “The breakevens are not high by any long-term standards, and they don’t show any signs of becoming unanchored,” Hood said.

2. Long-term inflation expectations from the University of Michigan consumer survey

The monthly consumer confidence survey conducted by the University of Michigan includes short- and long-term inflation expectations, according to Hood. And that means it captures forecasts made by average Americans.

Since 2000, the number has averaged 2.9%, but a move to the 3.2% area that lasts for six months or more would suggest “that expectations are coming unglued, with readings of 3.6% or higher generating even more concern,” according to Hood.

3. Employment cost index

In order for a true inflationary process to become entrenched in the economy, wage growth needs to participate, said Hood. Thus, tracking wage increase is an essential component of inflation-watching.

And the index to watch is the Employment Cost Index (ECI). Though published only quarterly it is broad in its coverage and includes benefit costs along with wages.

The ECI, which stands roughly at 2%, would need to “accelerate to a 3.5%-4.25% pace before triggering significant concern,” Hood wrote.

Any measure of wage inflation is really not showing anything much,” said Hood. Even the trend with the average hourly earnings report which is published monthly is “quite meager,” said Hood.

Inflation could spike up for any number of reasons, but unless it winds up affecting the labor market, it’s very likely to dissipate quickly, said Hood.

4. The Fed’s long-run forecast for the unemployment rate

The Federal Open Market Committee each quarter forecasts various economic variables, including the long-run unemployment rate. “The longer run unemployment rate can be taken as an estimate of a ‘neutral jobless rate’ which is defined as the level of joblessness consistent with stable inflation,” according to Hood.

If the estimate goes up, it’s a signal that the economy has less spare capacity than previously thought, Hood wrote. On the other hand, Hood wrote, if the neutral unemployment rate is higher than the Fed’s estimate some fear that the Fed will maintain easy policies for too long.

To be fair, economists understand that the neutral jobless rate is less stable than once was thought, but “investors should still monitor the relationship between the actual unemployment rate, the Fed’s neutral-rate estimate, and other indicators of market slack for signs that pressure is building,” Hood wrote.

“At the moment, with unemployment at 8%, compared with the Fed’s long-run jobless rate projection of 5.2%-6%, there seems little doubt that the labor market is operating with significant spare capacity,” according to Hood.

“You can argue about whether something has structurally changed in labor markets since the recession,” said Hood. “How much capacity has been destroyed there? Whether the labor market is going to take a long time to function efficiently? But even if you quibble with the Fed’s estimate of where the neutral unemployment rate would be, it’s pretty hard to dispute that there is a lot of slack back in the labor market.”

5. ISM nonmanufacturing survey prices component

Central banks, according to Hood, pay extra attention to inflation in services. The notion being that services inflation is most susceptible to influence by domestic growth and monetary developments, Hood said.

Hood also noted that the ISM nonmanufacturing survey, which is published monthly, should be watched less for a particular level and more for a large and sustained increase. That would trigger concern, he said.

At the moment, the ISM which had ticked up, “remains below its six-moth earlier level, consistent with an ‘all-clear’ signal for now,” according to Hood.

“It’s leveled off, but you can think about what would tend to drive that,” Hood said. “That’s likely to be related to capacity pressures. If you think about services inflation, this is not the goods price inflation gets pushed around by things like oil and grains; this is in a sense another check on whether the economy is operating with some degree of slack. What’s going to drive inflation in the services sector comes back in significant degree to labor.”

6. Overall commodity prices

The last three indicators capture global trends, and relate to pressure on available resources, according to Hood. And broad measures of commodity prices are one window into those dynamics, he wrote.

Hood said no one commodity is perfect so it’s best to look at trends in three or four high-profile indices, including the Thomson Reuters/Jefferies CRB index and the J.P. Morgan Commodity Curve Index. “At the moment, commodity indices are signaling little or no pressure on global prices,” Hood said.

To get a sense of whether inflation is on the rise here, look at the year-over-year percent change in the CRB index using a 12-month moving average. Anything above 20% would be cause for concern, and anything above 40% would really be cause for concern. Hood, for the record, cautioned investors against over focusing on commodity price indices when watching for inflation.

7. The Baltic Dry index

It’s not every day you get to bring up the Baltic Dry index, which tracks global shipping costs, in conversation at the soccer field. But this indicator is well worth watching too, said Hood.

Reuters

A container ship leaves the Port of Los Angeles.

The Baltic Dry index a real-time reading on trade activity and thus the relationship of economic growth and available resources. And it tends to capture inflection points in the global cycle, according to Hood.

“This is a good global indicator,” said Hood. “It’s one that is correlated with global trade activity, because it’s shipping costs. Global trade activity is highly correlated with overall global growth. And so this is an indicator of when global growth is bumping up against capacity constraints. If there are literally not enough ships to go around to carry the goods that are being imported and exported around the world, then the price of shipping will go up and that will be an early indicator that, in general, the global economy is straining against its speed limit.”

The Baltic Dry index has stabilized since is early 2012 plunge but remains far below its 2011 average, said Hood.

When watching for inflation, look at the year-over-year index change. Anything less than 3,000 is good; anything between 3,000 and 5,000 is in the yellow zone; and any reading above 5,000 is time to sound the red-zone alarm.

8. Chinese renminbi (CNY)

“In addition to its small but direct influence on inflation in the U.S. and elsewhere, movements in the CNY can serve as a summary measure of China’s role in the world as well as of the global economy itself,” Hood wrote in his report. “CNY appreciation will occur when Chinese policy makers feel comfortable with both international and local economic conditions — circumstances more likely to generate pressure on inflation.”

At the moment, the CNY is depreciating.

So there you have it. You don’t need to worry about inflation — at least according to Hood’s indicators — for the time being. Even better, you can now set up your own station to watch for signs of inflation on the horizon.

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